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Page history last edited by Brian D Butler 11 years ago


see also:

European Economic and Monetary Union - EMU - Euro - history




There are currently (as of Nov 2010) ... 16 members of the Euro-zone.  Estonia is scheduled to be the next member, joining in 2011. 

Other European Union members waiting to join the Euro:  "another eight countries are not yet ready to join the single currency. They are: Bulgaria, the Czech Republic, Latvia, Lithuania, Hungary, Poland, Romania and Sweden. The UK and Denmark have a legal opt-out."[1]


"To join" or "not to join"... that is the question:

"Support for joining the eurozone has fallen in many of these countries as a result of the Greek debt crisis. In a survey carried out by the Warsaw School of Economics in April, only 42.2 percent of respondents supported Poland's entry into the euro zone, down from 55.2 percent a year ago.  Despite not having a legal opt-out, Sweden has decided to indefinitely delay its eurozone entry. Polish Prime Minister Donald Tusk recently indicated that his country will do the same.  "Today I prefer to show a cautious stance. We will be following further developments in the south [of Europe] and will come back to the euro issue later," Mr Tusk said on 6 May."  [2]



The EU and the Euro


  • see our page on the European Union
  • Question - should Ireland have been forced to accept a bailout in order to protect other European countries (from the bond markets)?  Read discussion online here
  • Question - if the Euro were to fail as a currency, would the EU fail as a political project?  Could the EU survive if the Euro fails?  
  • Quote:  "Speaking hours before eurozone ministers meet to address threats to the bloc's economic stability, Herman Van Rompuy said that if the euro failed, so too would the EU...he added: "We all have to work together in order to survive with the eurozone, because if we don't survive with the eurozone we will not survive with the European Union." [3] 


Recommended Reading




Table of Contents:


Germany plays a central role in the Euro:

in the late 1980s the D-Mark, i.e. the anchor currency of the European fixed exchange rate mechanism (ERM) to which all other currencies were pegged in a narrow trading range



Will the Euro survive the global Credit crisis?


Milton Friedman famously predicted that the euro would not last past their first economic crisis.


Speculators give up to 20% chance of failure...see http://www.bloomberg.com/apps/news?pid=20601087&sid=a80P6StkcvnM&refer=home









CDS - Credit default swaps - to measure stress


As you can see from chart 3 below, investors in long dated Greek government bonds now earn about 2.5% more than they do by investing in correspondent German bunds.


Chart 3: PIGS Sovereign Debt Spreads over Germany

PIGS Sovereign Debt Spreads over Germany

Source: Goldman Sachs, European Weekly, 22/01/2009



Why NOT to leave:


borrowing costs would increase dramatically for any country that would leave.  Why?  Well, foreign investors would know that they ONLY reason to leave would be to devalue (or have the option of devaluing) the currency.  So, investors would demand much higher interest rates to compensate for that risk!  For this reason, its unlikely that any of the "PIGS" would opt to leave the EURO.


"important being economic costs. Take Italy which has a history of compensating for lost competitiveness through regular devaluations. If Berlusconi did the unthinkable tomorrow (sorry – nothing is unthinkable in Berlusconi's world), Italy's borrowing costs would explode. My guess is that bond investors would demand double digit returns on a Lira denominated bond to compensate for the dramatically increased devaluation risk. Already in a precarious fiscal position, Italy could quite simply not afford that."  read more:  http://www.arpllp.com/core_files/The%20Absolute%20Return%20Letter%200209(1).pdf




Case to join:  Ireland vs Iceland:


The case of Ireland gives good reason to be INSIDE the Euro...the case of Iceland does as well (or, a reason NOT to be OUTSIDE).







Could a member default?  (and stay in the union?)


it is not inconceivable that a member country could be forced to default on its sovereign debt. Interestingly, any euro member country defaulting on its debt could (and probably would) carry on as a full member of the currency union. And I will bet almost anything that the EU would rather have one of its members defaulting on its debt than having to break up the currency union.





Euro vs. Dollar FX rate:





Ten years ago the Eurozone consisted of only 11 countries – Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. As of January 1st, 2009 Slovakia is the 16th country to join the Eurozone.


The economic crisis is causing some countries to consider adopting the Euro, such as Denmark who has kept its own currency for many years now. On the other hand, countries such as Estonia, Lithuania, and Latvia had to postpone joining the Eurozone as the global economic crisis has caused problems for them.


Slovakia joined the currency union 2009, and will most definitely serve as an example in the future when deciding the entry of countries from the same region. This is because if the change of currency goes smoothly for Slovakia, countries such as Hungary and Poland (both of which will most likely be next to adopt the Euro as their official currency) can use it as an argument why they should be part of the Eurozone as well.







NOT members (buy might need to consider membership)...




Currencies PEGGED to the EURO:


Baltic states and Bulgaria (which already peg their currencies to the euro).


Three former communist countries where the currency was pegged to the German mark:

  1. Bosnia-Herzogovina
  2. Bulgaria - Lev (BGL)
  3. Macedonia - Denar MKD


Two more European Union countries:

  1. Denmark
  2. Hungary  WAS pegged the forint to the euro in January 2000. But after loosening the tie in May 2001 it abandoned the peg on 26 February 2008 [4]




Conditions to become a member:


euro-adopters must meet a European Union (EU) rule that stipulates a “high degree of price stability”, meaning that inflation must be no more than 1.5 percentage points higher than the three best-performing countries. (The other rules are less controversial. The second is sound public finances, meaning a government deficit below 3% of GDP and government debt below 60%. The third is stable exchange rates and the fourth is low long-term interest rates.)


Problem with this...=as poor countries (such as the ex-communist states of eastern Europe) get richer, they should enjoy an appreciating exchange rate if their currency floats. But if they have their currency pegged, then it can’t appreciate. So prices and wages measured in the local currency will rise instead (economists call that the Balassa-Samuelson effect).


Loose Rules (ignored rules)


Growth and Stability Pact rules ignored:


As of September 2010, "all 16 members of the euro zone now breach the 3% deficit threshold, and 12 also violate the 60% debt limit. They are not about to engage in mutual flagellation. The new rules will not be retrospective, and many sanctions will not bite until 2013. There is an escape clause to avoid penalties if Europe faces a general shock such as the financial crisis."   Read more from the Economist.com here




Repo Market:


The repo market is extremely important for the ECB and the EURO...see more here:  repo market




LIBOR.....and Sonia & Eonia:


see more on our discussion of  LIBOR


overnight interest rates, known as the Sonia for sterling and Eonia for the eurozone. These are the base off which interbank rates take their cue


Why they are important:  "Some economists and analysts think that the ECB is pursuing a twin-pronged strategy that differentiates between a base rate that is important among the broader population and a financial interest rate that is the real driver of the cost of credit."  Source:  ft.com




Interest rates




source:  http://www.ft.com/cms/s/0/5b9ef378-f489-11dd-8e76-0000779fd2ac.html#












More from Wikipedia:  Euro


 The euro is the official currency of the Eurozone (also known as the Euro Area or the Euro Land), which consists of 13 European states (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia, and Spain) and will extend to include Cyprus and Malta from 1 January 2008. It is the single currency for more than 320 million Europeans. Including areas using currencies pegged to the euro, the euro directly affects more than 480 million people worldwide.


see also:  European Banking Industry


Good things:

  • more stability (less volatility)
  • more international confidence
  • leads to more international trade
  • some economists claim that a common currency area, such as the Euro has led to lower levels of inflation, and lower interest rates (the lower inflation claim is highly debated...is it cause and effect?  or, pure coincidence?)


Bad things:

  • In a free floating regime, there is no way for a country to have a balance of payments crisis because the Currency will adjust.  But when the currency fixed, or pegged to another currency, it is possible to have a BOP crisis (think "tequila crisis" in Mexico).
  • the Euro zone has seen lower GDP growth than the UK  (which did not join the Euro) since its adoption.  Also, the UK has seen lower levels of unemployment.  Did the adoption of the common currency lead to a lower growth and higher unemployment?  This topic is highly debated by economists. 



Challenges for the Euro 


One weakness of the Eurozone as compared to the USA, is that Europeans are less likely to move to where the new jobs are.  In the US, if jobs are moving from Michigan to South Carolina, then families move.  But if European jobs move from Germany to Poland, the Germans are less likely to move.  They want jobs locally, and care less about jobs or growth in other parts of Europe.   The euro is underpinned by the Stability and Growth Pact, which is designed to ensure even fiscal policy across the Eurozone. The SGP has been criticised for removing the ability of national governments to stimulate their own economies to a certain extent, in the only way left to them now that monetary policy is determined supranationally. 



Up until now, the Euro has not been tested by a major crisis.  If there were suddenly a major recession in Germany, and if the German government wanted to cut interest rates to spur growth, but if they were not "allowed" because the EU was worried about inflation in Spain...I dont think most Germans would care.  And, since the membership of the Euro-club is optional, then it makes sense that one day a major country like Germany or France will opt out of the agreement. 


some facts vs the Euro:


  • The UK has done better than all EU since the Euro was adopted
  • Note:  convergence of Euro-zone inflation occurred before the adoption of the Euro, so it can not be accredited with taming inflation
  • but, interest rates did go down as a result of Euro adoption  (UK interest rates are higher)
  • There has been a convergence of grown rates...but not as expected...instead of being higher...it has been lower (compare vs. UK)
  • Also, unemployment has been higher (compare again with UK).
  • So, Euro adoption has led to lower growth, and higher unemployment.  Yikes, not good.


Also note that no currency regime has ever lasted longer than 60 years ...so, history says that the odds are against a long-running fixed currency regime.  But, only time will really tell...




Benefits of the Euro


there has been a 3x increase in the volume of trade.




Transaction costs and risks

The most obvious benefit of adopting a single currency is removing from trade the cost of exchanging currency, theoretically allowing businesses and individuals to consummate previously unprofitable trades. On the consumer side, banks in the Eurozone must charge the same for intra-member cross-border transactions as purely domestic transactions for electronic payments (e.g. credit cards, debit cards and cash machine withdrawals).


The absence of distinct currencies also removes exchange rate risks. The risk of unanticipated exchange rate movement has always added an additional risk or uncertainty for companies or individuals looking to invest or trade outside their own currency zones. Companies that hedge against this risk will no longer need to shoulder this additional cost. The reduction in risk is particularly important for countries whose currencies have traditionally fluctuated a great deal, particularly the Mediterranean nations.


Financial markets on the continent are expected to be far more liquid and flexible than they were in the past. The reduction in cross-border transaction costs will allow larger banking firms to provide a wider array of banking services that can compete across and beyond the Eurozone.




Price parity

Another effect of the common European currency is that differences in prices—in particular in price levels—should decrease because of the 'law of one price'. Differences in prices can trigger arbitrage, i.e. speculative trade in a commodity between countries purely to exploit the price differential, which will tend to equalise prices across the euro area. Similarly, price transparency across borders should help consumers find lower cost goods or services. In reality, the effects of the euro over the level of the prices in Europe are disputable. Many citizens cite the strong perceived increase in prices in the years after the introduction of the euro, although numerous empirical studies have failed to find much real evidence of this.  It is speculated that the reason for this perception is that the prices of small, everyday items were rounded up significantly. For example, a cup of coffee that once cost two German Mark might now cost €1.50 or even €2.00—a 50–100% increase, although wages in many countries have also increased. At the same time, a large appliance or rent payment rounded up to the next obvious euro level would be a negligible proportional increase. The fact that the prices people see every day were affected more strongly might explain why so many people perceive the "euro effect" as being significant, while official studies—which look at the breadth of expenditures, in proportion—would downplay it




Macroeconomic stability

Low levels of inflation are the hallmark of stable and modern economies. Because a high level of inflation acts as a highly regressive tax (seigniorage) and theoretically discourages investment, it is generally viewed as undesirable. In spite of the downside, many countries have been unable or unwilling to deal with serious inflationary pressures. Some countries have successfully contained them by establishing largely independent central banks. One such bank was the Bundesbank in Germany; as the European Central Bank is modelled on the Bundesbank, it is independent of the pressures of national governments and has a mandate to keep inflationary pressures low. Member countries join the bank to credibly commit to lower inflation, hoping to enjoy the macroeconomic stability associated with low levels of expected inflation. The ECB (unlike the Federal Reserve in the United States of America) does not have a second objective to sustain growth and employment.


National and corporate bonds denominated in euro are significantly more liquid and have lower interest rates than was historically the case when denominated in legacy currencies. While increased liquidity may lower the nominal interest rate on the bond, denominating the bond in a currency with low levels of inflation arguably plays a much larger role. A credible commitment to low levels of inflation and a stable debt reduces the risk that the value of the debt will be eroded by higher levels of inflation or default in the future, allowing debt to be issued at a lower nominal interest rate.



Comparing to the USA - dollar


In the United States, arguably that largest currency union in the world, fiscal transfers between member states allow for the federal government to adjust for variances in economic performances. There is no such mechanism within the euro zone, which explains why the member states are subjected to a number of rules1. These rules require for everyone to exercise a high level of economic discipline


Limitations on individual states

There are provisions to how much debt you can issue. Spain can not simply debit and credit accounts like I wrote above. Plus, the ECB can not monetize any new EU debt via the primary markets, like the Fed can do with Treasuries.


USA states CAN run deficits, but they CANNOT finance them or borrow. They must cut expenses or tap into various reserves. The Federal gov't often bails out various states through various methods, but states CANNOT finance their deficits.


Central banks in Europe:  The central banks of the eurozone nations really only have a few nominal responsibilities now...to uphold ECB mandates on a local level, issue EUR on a local level, maintain the sovereign's own reserves, help the ECB supervise local banks, and help the ECB by acting as a local clearinghouse. They are basically just around to "help out" with the ECB's duties.



Unit Labor Costs:


In the EU, there is a huge spread in the rise of unit labour costs over the past few years. Unit labour costs measure labor (wage) costs adjusted for changes in productivity. It is probably the best measure that exists in terms of tracking the changes in competitiveness between nations. When the Stability and Growth Pact behind the euro was established, there was no reference made to unit labour costs which, with the benefit of hindsight, was a major mistake. Even Jean-Claude Trichet, the Head of the European Central Bank, who rarely admits mistakes, has publicly stated that if he could design the currency union all over again, he would push for a unit labour cost stability pact.


Table 1: 2007 Unit Labour Cost Index (2000=100)

2007 Unit Labour Cost Index

Notes: *2006. PIGS countries in bold. Source: http://stats.oecd.org/


If countries do not leave the Euro and devalue....than another potential outcome is the possibility of one or more member countries coming under EU administration. This would almost certainly include the most painful of all cures – mandatory wage reductions in order to get unit labour costs back in line. It would be a lot easier for the government of, say, Greece to get the EU to do the dirty job than to do it itself. Civil unrest will no longer be the privilege of countries such as Indonesia or Thailand. The recent crowd trouble in Greece could very well turn out to be the dry run for much bigger and more organised labour market unrest across Europe as reality begins to bite.


But, NOT able to devalue....


UK has been able to play a card which is not at the disposal of the euro zone members. That card is called devaluation. Whether by design or otherwise, the UK has received a massive boost to its competitiveness in recent months as a result of the sharp fall in the value of the pound. Italy used to play this card repeatedly back in the days of the Lira. So did countries like Denmark in the dark days of the 1970s.


So, in a way...the Euro reduces the ability for "competitve devaluations"....and less beggar-thy-neighbor chances....unless some country chooses to leave in order to take advantage of this possiblity...



Structural deficits (coming soon)...


Another issue, which is potentially even more destabilising for the euro longer term, is the massive liabilities facing Europe as its population ages. We have borrowed table 2 below from Goldman Sachs which makes no secret of the challenges facing a number of European countries. Greece is clearly facing the biggest challenge. Public debt, which currently stands at about 95% of GDP, will grow to a whopping 555% of GDP by 2050 if the current pension and social security programme is left unchanged. The Greek government is painfully aware of this and have been working on several new initiatives. It was the passing of one of those new laws which caused the riots in Athens before Christmas.


Table 2: Actual Debt & Age Related Contingent Liabilities

Actual Debt and Age Related Contingent Liabilites

Source: Goldman Sachs, European Weekly, 22/01/2009


The UK will offer a great case study to test whether devaluations are still a powerful tool



Future of the Euro in Global Markets:


A new reserve currency?

The euro is widely perceived to be a major global reserve currency, sharing that status with the U.S. dollar (USD), albeit to a lesser degree. The U.S. dollar continues to enjoy its status as the primary reserve of most commercial and central banks worldwide.


Since its introduction, the euro has been the second most widely-held international reserve currency after the U.S. dollar. The euro inherited this status from the German mark, and since its introduction, has increased its standing somewhat, mostly at the expense of the dollar. The possibility for the euro to become the first international reserve currency in the near future is now widely debated among economists. Former Federal Reserve Chairman Alan Greenspan gave his opinion in September 2007 by stating that the euro could indeed replace the U.S. dollar as the world's primary reserve currency. He said that it is "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency."


Additionally, there has been some suggestion that the recent weakness of the US dollar might encourage various parties to increase their reserves in euro at the expense of the dollar.







Topics I find important now:

march 2009:


  • Global imbalances - savings glut
  • Balance of Payments - current account vs capial account
  • US as "borrower of last resort",
  • Fragility of finance
  • borrow short, lend long
  • Fragility of international finance...borrow in foreign currency
  • "pyramid of promises"
  • Importance of property rights, and trust
  • Deleveraging  (KEY TOPIC)...what it means
  • "shadow banking" (another key topic)
  • Importance of borrowing in own currency, and local capital markets
  • Banking crisis + currency crisis= the "twin crisis"
  • US balance of payments
  • US borrowing in own currency...a unique position
  • hedging
  • European
  • Role of Germany in  Euro
  • "P-I-G-S" - southern Europe
  • Maastricht treaty
  • UK, Switzerland & others outside currency union
  • West Balkans , Baltics, Iceland..... the value of stabiliyt during crisis
  • Debt levels in Eastern Europe
  • IMF, World Bank and Eastern Europe
  • Russia & oil...and eastern europe crisis
  • Leverage of European Banks
  • lack of common bond market in Europe -- see discussion here ... (Europe and global credit crisis)
  • how to pay for stimulus....
  • balanced budget constraints
  • banks with exposure to Eastern Europe.
  • Carry trade unwinding....borrining in Switzerland, investing in Hungary
  • UK and currency devaluations....falling pound. 
  • UK and banking center
  • weakness of Euro
  • benefits of Euro
  • International "reserve" currency (USD vs Euro")
  • Optimal currency union
  • Mobility of labor
  • Currency devaluations...competitive devaluations, "begggar thy neighbor"


Links / Sources:








  1. http://euobserver.com/9/30068
  2. http://euobserver.com/9/30068
  3. http://www.bbc.co.uk/news/business-11762500
  4. http://www.web40571.clarahost.co.uk/currency/Euro/eurocountries.htm

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